Warranty provisions made on scientific & Reasonable basis is allowable

IN THE ITAT BANGALORE BENCH ‘A’

Textronix India (P.) Ltd.

Versus

Deputy Commissioner of Income-tax

IT Appeal No. 1334 (Bang.) of 2010

[Assessment year 2006-07]

October 31, 2012

ORDER

N.V. Vasudevan, Judicial Member – This is an appeal filed by the assessee against the order dated 20-9-2010 passed by the DCIT, Circle 12(4), Bangalore, u/s 143(3) r.w.s.l44C of the Income-tax Act, 1961 [hereinafter referred to as “the Act”].

2. The assessee has filed concise grounds of appeal. Ground Nos.9 and 10 in the concise grounds of appeal were not pressed and the same are dismissed as not pressed. Ground No. 1 is general in nature and caffs for no specific adjudication.

3. Ground Nos.2 to 7 raised by the assessee are with regard to transfer pricing adjustment made by the AO which was confirmed partly by the Dispute Resolution Panel (DRP).

4. The material facts with regard to the aforesaid issue are as follows: The assessee is a company which is engaged in the business of distribution of telecom equipment, logic analysers and other test and measurement equipments and accessories on behalf of its Associate Enterprise (AE). Besides the above, if a customer in India wants to purchase the equipment directly from the AE, the assessee acts as intermediary and derives commission income for services rendered. These are the two streams of revenue which the assessee derives from carrying out transactions with its AE. It is not in dispute that the transaction between the assessee and its AE was an international transaction and the income arising from such transaction has to be computed in accordance with the provisions of sec.92 of the Act that having regard to the Arms’ Length Price (ALP). The assessee conducted a transfer pricing study in respect of its trading activity as well as commission agency activity (which is referred to as indent sales activity in the TPO’s order). The most appropriate method selected by the assessee was TNMM. The stand of the assessee in the transfer pricing study, the TPO’s adjustment in respect of the claim of the assessee and the DRP’s directions may be summarized in the form of following chart:

Aggrieved by the addition sustained by the AO consequent to the directions of the DRP, the assessee has raised ground Nos. 2 to 7 before the Tribunal.

5. Learned counsel for the assessee submitted before us no doubt it had selected as the most appropriate method the TNMM. It was pointed out that the assessee in its transfer pricing study had taken both the trading activity as well as the commission agency business on a combined basis and carried out the transfer pricing study. It was submitted that the TPO asked for segment data of the trading activity and the commission agency activity separately and thereafter worked out the margin in both the activities and arrived at the adjustment. It was submitted that by the learned counsel for the assessee that the most appropriate method that could be applied for determining the ALP would be the resale price method (RPM). In this regard, the learned. counsel for the assessee drew our attention to the decision of the ITAT, Mumbai ‘L’ Bench, in ITA No.5423/Mum/2009 dated 25-4-2012 in the case of ITO v. L’Oreal India Pvt. Ltd. [2012] 53 SOT 263 (Mum.) (URO) wherein the Tribunal had to deal with the case of an assessee who was having two segments namely manufacturing and distribution of a consumable product. The question before the Tribunal was as to the most appropriate method for determining the ALP in respect of business activity relating to the distribution segment. The Tribunal, in para. 18 and 19 of its judgment had held as follows:

“18. The only question for our consideration is as to whether to determine ALP in respect of business activity relating to distribution segment of the assessee with the AE is to be considered by RPM or TNMM. We observe that TPO has applied TNMM and has suggested adjustment of Rs.4,90,07,000 by showing desired profits margin of comparable companies at 0.36% on sales as the operating margin of the assessee shown is (-) 19.84%. Accordingly TPO computed the ALP in the purchase of finished goods at Rs. 2,70,81,000 as against actual value of Rs. 7,60,88,729 shown by the assessee. We observe that TPO stated that the assessee has adopted RPM for determining the ALP for the import of finished goods. He has stated that the assessee has determined gross profit margin by taking difference between costs of purchase of value of sales. The assessee has stated that the gross profit margin in the distribution activity was 40.80% vis-a-vis comparable companies identified by the assessee, earned margin of 14.85%. However, TPO suggested that as per Rule 10B(2) of Income Tax Rules, for the purpose of determining ALP, the comparable transaction considered by the assessee must be similar to the international transaction in terms of similarity in the characteristics of the product and the functions performed, assets employed and risks assumed in the controlled transaction and the uncontrolled transaction must also be similar. Accordingly, TPO did not agree with the comparable companies considered by the assessee. He also stated that RPM could be an appropriate method only when there is no value addition undertaken by the distributor. The TPO considered the selling and distribution expenses in marketing and stated that there is a value addition by the assessee and thus TNMM is the most appropriate method. The TPO did not accept the adjustment given by the assessee and, accordingly, made this addition.

19. During the course of hearing, Id DR also supported the method considered by TPO and referred to para 2.29 of OECD Price Guidelines 2010 as stated hereinabove. On the other hand, ld. AR justified the RPM method adopted by it and also referred to order of TPO in the preceding assessment years as well as succeeding assessment years to the assessment year under consideration to substantiate that RPM is the most appropriate method to determine ALP. He submitted that the assessee made adjustment for marketing and selling expenses to the profits to make it comparable to the comparable companies’ profits. We agree with Id CIT(A) that there is no order of priority of methods to determine ALP. RPM is one of the standard method and OECD guidelines also states that in case of distribution and marketing activities when the goods are purchased from AEs which are sold to unrelated parties, RPM is the most appropriate method…..”

Pointing out to the above decision, learned counsel for the assessee submitted that RPM should be the most appropriate method to be followed in the case of the assessee. Thereafter the learned counsel for the assessee drew our attention to the gross profit margin of the assessee which was 35.61% which was much higher than the arithmetic mean of the GP margin of the comparables selected by the TPO himself which was only 12.90%. It was submitted by him that the RPM which is the GP margin method, if taken as most appropriate method, then the assessee’s GP margin was much better than the comparables identified by the TPO himself and therefore no adjustment by way of addition to ALP is required to be made. In this regard it was submitted that the issue was not raised by the assessee before the TPO but the same was raised before the DRP. The DRP has given no specific reason for rejecting the claim of the assessee but has merely observed that no comments in view of the fact that the transfer pricing study of the TPO has been re-examined and the objections raised does not have any direct relevance to it. (point 39, page 17 of the DRP’s order).

The learned Departmental Representative, on the other hand, relied on the order of the DRP and submitted that the assessee has not raised the issue specifically before the TPO.

We have considered the rival submissions. The dispute is with regard to the ALP in respect of international transactions whereby the assessee imports equipments from its AE and re-sells them without any value addition to the Indian customers. In similar circumstances, Mumbai Bench of the Tribunal in the case of L’Oreal India Pvt. Ltd. (supra) has taken the view that the RPM would be the most appropriate method for determining the ALP. The Mumbai Bench of Tribunal, in this regard, has referred to the OECD guidelines wherein a view has been expressed that RPM would be the best method when a re-sale takes place without any value addition to a product. In the present case, the assessee buys products from the AE and sells it without any value addition to the Indian customers. In such circumstances, we are of the view that the ratio laid down by the Mumbai Bench of the Tribunal in the case of L’Oreal India Pvt. Ltd. (supra) would be squarely applicable to the facts of the assessee’s case. In that event, the GP as a percentage of sales arrived at by the TPO in Annexure to the TPO’s order insofar as trading activity of comparables identified by the TPO at 12.90%. The GP as a percentage of sales of the assessee is at 35.6% which is much above the percentage of comparables identified by the TPO. In such circumstances, we are of the view that no adjustment could be made by way of ALP. We, therefore, accept the alternative plea of the assessee and delete the addition made by the AO. In view of the above conclusion, we are not going into the other issues on merits raised by the assessee on the approach adopted by the TPO in arriving at the ALP. Thus, ground Nos.2 to 7 are allowed.

Ground No.8 raised by the assessee reads as under:

“The Hon’ble DRP and the learned AO have erred In law and on facts in disallowing the provision for warranty expenses, without considering that it was computed on a scientific and consistent basis as per the principles settled by the courts.”

During the FY 2005-06, the assessee created provision of Rs. 19,09,604 for warranty support on the products sold during the year. The learned AO has disallowed the provision treating it as an unascertained liability.

6.1 In this regard, the following facts were highlighted by the assessee before the DRP.

   •  The products sold by the assessee were sophisticated products involving complex technology. During the FY 2005-06, the assessee had sold 26 different types of products.

   •  Three types of warranty were provided by the assessee. While a 1 year warranty is provided for most products, a 3 year warranty is provided in respect of 5 products while a 90 day warranty is provided in respect of provision of customer/maintenance service.

   •  The warranty reserve is computed on a scientific basis as detailed in the appellant’s detailed warranty policy. The policy considers various relevant factors including the following:

   –  Warranty period granted for a particular product

   –  Warranty expenses (Labour and material costs) incurred in the preceding 12 months for each product

   –  Expected changes in the prices/inflation pertaining to labour or material costs which could impact the level of warranty expenses to be incurred in the future (referred to in Assessee’s warranty policy as Labour cost adjustment factor or Material cost adjustment factor).

   –  Probability of claims arising specific to the warranty period attached to each product (referred to in assessee’s warranty policy as Accrual factor)

   –  Expected growth in warranty expenses as a result of the growth In the sales of products covered by warranty cover (referred to in assessee’s warranty policy as Sales factor)

   –  Each of the factors including assumptions on probability of claims etc are supported by sound rationale as detailed in the warranty policy

   •  The warranty reserve is reviewed by the assessee at the end of every quarter with reference to the level of actual warranty expenses in the preceding 12 month period and the relatable sales.

   •  The warranty provision Is thus provided to the extent necessary and reviewed on a consistent basis. It is in accordance with the accepted accounting principles and has been audited by the Chartered Accountants, who have also reported that the financial statements are prepared in accordance with accepted accounting principles and reflect a true and fair view.

The assessee had provided detailed submissions vide its letter dated June 17, 2010 to the AO with a copy to the DRP (Page 1 to 7 of paper book) to explain the detailed and scientific manner in which the warranty provision is created and consistently reviewed by it. However, the AO did not consider the submission. In his remand report dated August 20, 2010 to the DRP. Further, the DRP too has observed (Refer page 3 of the DRP order) that the assessee had failed to establish that the warranty provision was made on a scientific basis. This conclusion is contrary to the facts of the case and is in violation of the principles of equity and natural justice.

6.2 Before us, learned counsel for the assessee reiterated the submissions as were made before the AO. Our attention was drawn to the methodology by which the provision for warranty was determined by the assessee. The same is annexed as annexure ‘A’ to this order.

It was submitted that the Hon’ble Supreme Court in the case of Rotork Controls (India)(P.) Ltd. v. CIT [2009] 314 ITR 62 has held that the provision for warranty liability is deductible on accrual basis. The Hon’ble Supreme Court has held that the reliable estimate of a liability arising from an obligating event of the past would be a justified basis of claiming expenditure. Further reference was made to the decision of the Hon’ble Delhi High Court in the case of CIT v. Ericssion Communications (P.) Ltd. [2009] 318 ITR 340 wherein the Hon’ble High Court has held that the liability on account of warranty computed on a scientific basis and by way of consistent policy adopted by the assessee should be accepted. It was also pointed out that similar claims were made by the assessee in the past but no disallowance was made by the revenue authorities.

6.3 The learned Departmental Representative, however, relied on the order of the DRP wherein the DRP has held that the assessee’s provision for warranty was not made on scientific basis.

7. We have considered the rival submissions. In the submissions before the DRP, the assessee has given a detailed basis on which provision for warranty has been arrived at. The same is given as annexure ‘B’ to this order. The DRP called for a remand report from the AO on this aspect. The AO has not given any finding as to whether the basis on which the assessee made provision for liability on account of warranty was scientific or not. The DRP merely relied on the report of the AO without examining as to whether the method of providing for warranty liability was on a scientific basis. We have perused the methodology of making provision for warranty reserve. It is seen from the methodology that the assessee takes into account the warranty liability for the accounting period after bifurcating the likely cost on account of labour, material etc. The summary of the provision also shows that wherever excess provision was made in an earlier year, the same is reversed in the subsequent period. The claim made by the assessee prima facie shows that the estimate Is made by the assessee on scientific basis and reasonable basis. Since neither the AO nor the DRP have given any contrary findings with regard to the methodology adopted by the assessee in making provision for warranty liability, we are of the view that the claim made by the assessee should be accepted. In this regard, we are also of the view the assessee satisfies the criteria for claiming deduction on account of provision for warranty as laid down by the Hon’ble Supreme Court in the case of Rotork Controls (P.) Ltd. (supra) and the Hon’ble Delhi High Court in the case of Ericssion Communications (P.) Ltd (supra). We, therefore, direct that the claim of the assessee in this regard should be allowed.

8. In the result, the appeal by the assessee is partly allowed.

NF